Transfer pricing for the automotive sector

November 2010 | TALKINGPOINT | SECTOR ANALYSIS

financierworldwide.com

FW moderates a discussion between Richard L. Slowinski at Baker & McKenzie, Steven C. Wrappe at Ernst & Young LLP and David N. Bowen at Grant Thornton LLP, on transfer pricing issues for automotive companies.

FW: Why is it so important for automotive companies to address transfer pricing issues?

Slowinski: It is critical for automotive companies to address transfer pricing issues for various reasons. The large volume of complex cross-border related-party transactions involving tangible and intangible goods, services, finance, and so on, engaged in by automotive companies, means that such transactions can have a significant impact on the results reported in various jurisdictions. Cross-border related-party transactions continue to increase in magnitude and change in nature as automotive companies adopt more regional structures to streamline operations. Due to the magnitude of their related party transactions, tax authorities have historically subjected automotive companies to heightened scrutiny, and such scrutiny continues today. As with all MNEs, values used for transfer pricing purposes can impact other regimes, such as customs and IP valuation, and therefore it is helpful to have certainty with regard to transfer pricing. Finally, automotive companies with defensible transfer pricing in place can achieve particular efficiencies, savings and certainty which may contribute to bottom line growth.

Bowen: The obvious answers to this are true for all multinationals: effective management of the worldwide effective tax rate, proactive dispute avoidance, appropriate planning and compliance, and so on. In other words, ‘the usual stuff’. Specifically for automotive companies, however, there is no denying that the companies were hit hard by the economic downturn. Everything from their internal structures to their supply chains were altered significantly – and in most cases permanently. And most have invested, or will invest, in R&D that is necessary to meet the demand for efficient manufacturing techniques and new alternative fuel and energy sources. It naturally follows, therefore, that the companies must effectively manage and determine the appropriate arm’s length results for the income, deductions, credits and allowances that result from their multinational activities.

FW: To what extent have increased monitoring and enforcement activities by tax authorities heightened transfer pricing risks for automotive companies?

Bowen: Naturally, one drives more carefully when one knows that the ‘cops are out’. The US cops are out – look, for example, to the restructuring of IRS-LMSB into ‘LB&I’, Large Business and International, which will have an industry specific focus. What is specifically relevant to car companies, however? For one thing, the historical, tax authority ‘force of attraction’ to economic losses within multinational enterprises (MNEs). That is, tax authorities, and particularly the IRS, have looked sceptically upon losses in an MNE setting. For example, the IRS typically, with limited exception, does not allow ‘loss comparables’ to benchmark arm’s length results. Yet we know that at arm’s length, companies can and do lose money. Thus, we have the perfect recipe for TP risks: the IRS’s longstanding position on ‘loss comparables’, the economic reality of the auto industry downturn, and the heightened enforcement initiatives.

Slowinski: These factors, combined with the recent economic downturn and restructurings, have significantly heightened transfer pricing risks for automotive companies. Tax authorities around the world, and even on a state and local basis, have increased compliance requirements and enforcement activities with regard to MNEs, including automotive companies. To mitigate the risks associated with the heightened enforcement, automotive companies should evaluate their intercompany agreements and transfer pricing documentation and determine whether the agreements and documentation are consistent with the relevant affiliates’ actual functions and risks. Given the unique effect of the economic downturn on automotive companies, companies need to consider carefully how to address, for transfer pricing purposes, sales declines, excess capacity, impairment charges, write-offs, restructuring expenses, plant closures, etc., and to minimise the likelihood that such effects of the economic downturn may contribute to transfer pricing exposure. Similarly, automotive companies less impacted by the economic downturn should evaluate how start-up expenses, plant ramp-up costs, vehicle launch costs and other factors should be taken into account in analysing their transfer prices.

FW: Can you outline the benefits of effective transfer pricing planning?

Slowinski: Effective transfer pricing planning can yield many benefits. It can reduce tax exposure and financial statement reserves and serve as a critical element of a broader business restructuring analysis intended to identify profit drivers of the business and streamline the business. For example, effective transfer pricing planning can reduce tax exposure by analysing a company’s intercompany transactions, including pricing, financial results of relevant affiliates, tax audit history, and so on, and developing and implementing a comprehensive plan to address exposure through modifications to prices, preparation of necessary documentation and possibly utilisation of alternative dispute resolution approaches, such as advance pricing agreements. At the other end of the spectrum, effective transfer pricing planning should be an integral part of a company’s overall efforts to evaluate, plan for and implement restructurings to streamline operations, increase free cash flow, monetise existing IP, improve key value drivers for the business and enhance competitiveness. Such restructurings can involve significant changes to intercompany transactions.

Bowen: The principle benefits are effective tax rate (ETR) management and dispute avoidance. Need I say more? Fortunately in my experience, car companies usually are at the forefront of TP planning, and many are in the APA program. That just makes good sense.

FW: What challenges are involved in valuing transactions and arm’s length pricing?

Bowen: Let’s start at the 30,000 foot level: car companies are truly unique. They have their own inimitable issues. To name just a few: Everything from vertical and horizontal integration, to legacy costs, changing technologies, complex distribution networks, high-margin replacement parts (warranty and repair), extensive dealer networks, intense competition, planned obsolescence, marketing incentives (rebates, price protections, buy-backs, etc.). And that’s just the beginning. Yet the rules require ‘arm’s length results’. But what is ‘arm’s length’ for a company that, by its inherent nature, does not look, act, or operate like many of the so-called ‘comparables’ that tax authorities, and often advisers, derive? The basic challenge, therefore, involves determining a practical TP solution for complex companies for which the concept of ‘comparables’ often is a stretch. From there, it gets more complicated.

Slowinski: Automotive companies provide unique challenges in valuing transactions and arm’s length pricing due to a number of factors. First of all, the high level of vertical integration within automotive companies makes it more likely that cross-border related-party transactions exist and more difficult to identify comparable uncontrolled transactions. Second, automotive operations tend to be highly capital intensive, which needs to be taken into account in performing transfer pricing analyses. Third, economic cycles can have a more dramatic effect on automotive companies than companies in other industries. Fourth, automotive parts companies and automobile assemblers tend to interact on a closer level in terms of parts design and engineering, just-in-time delivery, modularisation, assembly, and so on, which can yield unique advantages and disadvantages. Finally, certain automotive operations, such as distribution, can involve the performance of a range of interrelated and important functions and risks, such as importation, homologation, research, sales and marketing, warranty, after sales service, finance, and so on.

FW: Do automotive companies need to produce appropriate documentation to support claims of losses or reduced profits as they relate to transfer pricing?

Wrappe: The automotive industry has been hit hard by the current recession, resulting in losses and reduced profits across the industry. However, the recession’s impact has not been even across industries. Because transfer pricing documentation for automotive companies often relies upon functional comparables from other industries, the documentation that was reliable in previous, non-recession years may not be as reliable in the recession. A number of approaches have been developed to modify the existing transfer documentation to address recession-driven challenges. Some taxpayers have sought new comparables that more closely resemble the automotive tested party in a recession, particularly comparables that suffer decreased sales in the same way as the automotive industry. Others have fashioned adjustments to apply to the existing comparable sets to adjust for unforeseen circumstances, such as diminished plant capacity utilisation. Still others have extended the period for comparison, or relaxed the range from an interquartile range to some broader inclusion – for example, the full range. An important factor to keep in mind about these recession-driven adjustments is that governments expect some consistency in the transfer pricing analysis between periods. For example, a distributor that is allowed to bear losses in a recession period can be expected to earn more in a favourable economy than a distributor that does not bear losses in a recession.

Bowen: I would note that the recent losses or reduced profits do not necessarily relate to transfer pricing. Sometimes the blame falls squarely on economic conditions, and other factors having nothing to do with TP. However, getting a tax authority to recognise and accept economic reality, sometimes is a very difficult task. Thus the need for ‘appropriate documentation’ intensifies.

Slowinski: It is very important for automotive companies to produce appropriate transfer pricing documentation to support losses or reduced profits, particularly due to the unique manner in which the economic downturn has affected automotive companies. For example, losses or reduced profits due to severe sales declines, excess production capacity, restructuring costs, currency movements, etc., will need to be supported through appropriate documentation, including relevant intercompany agreements and legal and economic analyses. The need for such documentation is critical where the company defends its transfer prices through normal tax examination procedures which may occur several years after the events at issue, and therefore it is important to memorialise the relevant facts. To the extent that the company uses other procedures, such as advance pricing agreements, to reach agreement on the arm’s length nature of its transfer prices, then the need for such documentation is still important, but the documentation will be used on a more contemporaneous basis.

FW: For automotive companies in the process of reorganisation and restructuring, is this a good time to re-evaluate and overhaul their transfer pricing policy?

Bowen: Not only is it a good time, it is critical. One of the so-called ‘comparability factors’ under US law is, ‘economic conditions’. As everyone knows, the economy dealt devastating blows to the industry. Many of the companies will continue to feel the effects of those blows for many years to come. Now is the time not only to evaluate and ‘freshen’ the TP policy but to establish longer-term policies so that a policy set today does not result in a whipsaw, or boomerang, when economic conditions turn around.

Wrappe: In the current recession, some level of business restructuring is inevitable, especially in the automotive industry. The economic downturn has forced automotive companies to reassess operations and quickly adapt to survive. Automotive companies have already engaged in a number of business-driven changes which impact their transfer pricing. For example, they continue to pursue supply chain improvements to reduce costs and to move manufacturing to low-cost locations. Further, they have acquired or sold business operations or brands based on new corporate direction. Following these business-driven changes to intercompany transactions, companies need to revise old transfer pricing policies for the substantially changed facts and circumstances. Unfortunately, government and media attention paid to transfer pricing in recent years has been overwhelmingly negative and sceptical of business restructurings. Due to the compelling business need for the transactional changes in the automotive industry, companies should be able to overcome this bias against transfer pricing planning. Even the OECD, in its new Transfer Pricing Guidelines chapter on business restructurings (Chapter IX), acknowledges the company’s right to structure its own operations to maintain profitability.

Slowinski: Transfer pricing policies should be re-evaluated on a regular basis to ensure that they are consistent with actual practice, and it is particularly essential to do so during a reorganisation or restructuring. Tax authorities are placing more emphasis on ensuring that the economic substance of intercompany transactions is consistent with the terms set forth in the relevant agreements, including transfer pricing policies. If such consistency is lacking, a tax authority may have the discretion to disregard the transfer prices implemented by the company and impose transfer prices that it believes are consistent with the economic substance. Accordingly, in a situation where a company is undergoing a reorganisation or restructuring, it is imperative that the company modify its transfer pricing policy to be consistent with the new structure. Reorganisations and restructurings can also provide unique opportunities to implement more tax efficient transfer pricing policies.

FW: When centralising company operations – such as information technology and research & development – what transfer pricing considerations should automotive companies make?

Slowinski: The centralisation of IT, R&D and other operations provides an automotive company with an opportunity to rationalise its transfer pricing policy for such operations. For example, the centralisation may allow a company to transfer IP from many affiliates to an IP holding company which can then optimise the IP, licence it to affiliates and eliminate the need for numerous cross-licences of IP to and from various affiliates. The selection of the jurisdiction for the centralised IT and R&D operations is important from a transfer pricing perspective in terms of utilising NOLs, minimising withholding taxes on intercompany royalties, service fees, and so on, and providing mutual agreement procedures to reduce potential risks associated with permanent establishments or double taxation. Profits from the centralised IT and R&D operations can also be redeployed within the affiliated group as needed through intercompany loans, dividends, etc. Depending upon the jurisdictions involved, it may also be possible to use advance pricing agreements to provide certainty with regard to the automotive company’s transfer prices for the centralised IT and R&D functions.

Bowen: It is rather evident that there is no immediate end in sight to the relatively oppressive tax burden that the United States is placing on corporations. In that light, staring into the future, why would I want to locate my new, highly valuable intangibles in a tax jurisdiction that basically is not competitive on a worldwide scale? Indeed, under established principles, companies are under no obligation to arrange their affairs to pay the highest-possible amount of tax. Now, it’s true, of course, that the tax tail doesn’t always wag the dog. Nevertheless, considering the need for new technologies, car companies must consider the most tax-effective jurisdiction in which to locate their newest high-profit-potential intangibles.

Wrappe: This issue is really an important part of business restructuring. Business functions, assets and risks are being shifted, often across borders, with the centralisation of IT, R&D, and other functions. The same rules apply regarding the need for revised transfer pricing analysis and the restructuring chapter of the OECD’s transfer pricing guidelines is a good reference point from which to evaluate the change transaction and the resulting new structure.

FW: How can transfer pricing be used to optimise an automotive company’s intellectual property assets?

Bowen: US principles call for recognising income that is ‘commensurate’ with the income attributable to an intangible. Thus, why locate new intangibles in a high-tax jurisdiction like the US, or for that matter, Japan? Further, there are various ‘hot topics’ in the area of, ‘what is an intangible’. Goodwill, going concern value, and workforce in place are not defined specifically in the US statute, yet the IRS often asserts that their values are subject to the TP rules. This is a very hot topic right now – and one for which arguably the IRS is dead wrong.

Slowinski: Transfer pricing can optimise an automotive company’s intellectual property assets in numerous ways. With the continuing globalisation of the automotive industry and the importance of the emerging BRIC markets, automotive companies can further optimise the value of IP by locating and developing the IP in more cost-effective jurisdictions and licensing the IP to its engineering, design, manufacturing and distribution operations. With a heightened focus on the need to develop new technologies to survive, to increase collaboration between parts suppliers and automotive assemblers to develop jointly new IP or to enter into strategic alliances with other automotive companies to achieve certain economies of scale, it is even more important that automotive companies develop IP in as cost-effective a manner as possible.

Richard L. Slowinski is a Principal at Baker & McKenzie. His practice focuses on US federal income taxation of corporations, with an emphasis on international tax planning and controversies involving international tax issues. Ranked as a leading individual in taxation by International Tax Review’s World Tax Survey, Mr Slowinski has served on the firm’s North America Transfer Pricing Steering Committee and currently serves as hiring partner and associate development partner for the Washington office. He also worked in the Tokyo office of Baker & McKenzie/Tokyo Aoyama Aoki Koma Law Office. Mr Slowinski is a frequent presenter at seminars sponsored by the Tax Executives Institute, the Japan Tax Association and other professional organizations. He can be contacted on + 1 (202) 452 7025 or by email: richard.slowinski@bakermckenzie.com.

David Bowen is a Principal in Grant Thornton’s International Tax practice. He is the practice leader for the firm’s transfer pricing practice and is based in the National Tax Office in Washington, DC. He has over 24 years of experience in a wide variety of federal income tax matters. Prior to joining Grant Thornton, Mr Bowen spent several years as a partner with Mayer, Brown, Rowe & Maw working on federal income tax planning, tax controversies and transfer pricing. He can be contacted on +1 (202) 521 1580 or by email: David.Bowen@gt.com.

Steven C. Wrappe is a principal in Ernst & Young LLP’s International Tax Services National Transfer Pricing practice. He is located in Washington, DC, but also focuses on our West Coast Transfer Pricing practice. Mr Wrappe chairs the Ernst & Young LLP’s transfer pricing technical committee. He brings 30 years of tax experience, including nearly 20 years of extensive experience in all aspects of transfer pricing across all industries. His knowledge in transfer pricing controversy includes examination, appeals, alternative dispute resolutions, advance pricing agreements, mutual agreement procedures and customs agreements. Mr Wrappe’s combined advance pricing agreements and mutual agreement procedures experience is in excess of 100 cases. He can be contacted on +1 (202) 327 7956 or by email: steven.wrappe@ey.com.

THE PANELLISTS

Richard L. Slowinski

Baker & McKenzie

Steven C. Wrappe

Ernst & Young LLP

David N. Bowen

Grant Thornton LLP